Chapter 1FINANCIAL MARKETS & INSTITUTIONS

FINANCIAL MARKETS

Is a market in which financial assets such as stocks and bonds are traded.

They facilitate the flow of funds, allowing financing and investing.

Financial markets transfer funds from those who have excess funds to those who need funds

Participants of the market:◦Households◦Firms◦Government agencies

The ones providing funds to financial markets are called Surplus Units-(households)

Participants who use financial markets to obtain funds are called Deficit Units

Security:A certificate that represents a claim

on the issuer.

How do deficit units work:◦They issue (sell) securities to

surplus units IN order to obtain funds

TYPES OF FINANCIAL MARKETS

Primary versus secondary marketsNew securities are issued in primary

markets,while existing securities are traded in

secondary markets.–Facilitate the Trading of Existing Securities–Provide Liquidity–Continuous Information–Makes it easy for firms to raise Funds

Money versus Capital MarketsFinancial markets that facilitate

the flow of short-term funds (with maturities less than one year) are known as money markets,

While those that facilitate the flow of long-term funds are known as capital markets.

Organized versus Over-the-Counter Markets

Some secondary stock market transactions occur at an organized exchange, which is a visible market place for secondary market transactions.

Over the counter market is a telecommunication network for market transactions

Securities traded in Financial MarketsEquity securities represent

ownership in business.Debt securities represent IOU’S,

investors who purchase these securities are creditors.

While equity securities typically have no maturity, debt securities have maturities ranging from one day top twenty years or longer.

Securities traded Money market securities:

◦Are debt securities that have a maturity of one year or less.

◦Have a high degree of liquidity,◦Low expected return.

MONEY MARKET SECURITITES

ISSUED BY INVESTORS MATURITIES SECONDARY MARKET TRADING

TRESURY BILLS FEDERAL GOVERNMENT

HOUSEHOLDS, FIRM, FINANCIAL INSTITUTIONS

ONE YEAR OR LESS

HIGH

CERTIFICATE OF DEPOSITS

BANKS AND SAVING INSTITUTIONS

HOUSEHOLDS 7DAYS-5 YEARS OR LONGER

NONEXISTENT

NEGOTIABLE CD’S BANKS AND SAVING INSTITUTIONS

FIRMS 2 WEEKS- 1 YEAR MODERATE

COMMERCIAL PAPER

BANK HOLDING COMPANIES, FINANCING COMPANIES

FIRMS 1 DAY- 270 DAYS LOW

EURODOLLAR DEPOSITS

BANKS LOCATED OUTSIDE US

FIRMS AND GOVERNMENTS

1 DAY- 1 YEAR NON EXISTENT

BANKER’S ACCEPTANCES

BANKS FIRMS 30 DAYS- 270 DAYS

HIGH

FEDERAL FUNDS DEPOSITORY INSTITUTIONS

DEPOSITORY INSTITUTIONS

1 DAY- 7 DAYS NON EXISTENT

REPURCHASE AGREEMENTS

FIRMS AND FINANCIAL INSTITUTIONS

FIRMS AND FINANCIAL INSTITUTIONS

1 DAY- 15 DAYS NON EXISTENT

CAPITAL MARKET SECURITIESSecurities with a maturity of more

than one year.◦ Bonds and mortgages: are long term debt

obligations issued by corporations and government.

◦ Mortgages are debt obligations to finance real estate

◦ Stocks represent partial ownership in the firms that issue them, they have no maturity and serve as long-term source of funds.

CAPITAL MARKET SECURITITES

ISSUED BY INVESTORS MATURITIES SECONDARY MARKET TRADING

TRESURY NOTES AND BONDS

FEDERAL GOVERNMENT

HOUSEHOLDS, FIRM, FINANCIAL INSTITUTIONS

3-30 YEARS HIGH

MUNICIPAL BONDS

STATE AND LOCAL GEVERNMENT

HOUSEHOLD AND FIRMS

10-30 YEARS MODERATE

CORPORATE BONDS

FIRMS HOUSEHOLD AND FIRMS

10-30 YEARS MODERATE

MORTGAGES INDIVIDUAL AND FIRMS

FINANCIAL INSTITUTIONS

10-30 YEARS MODERATE

EQUITY SECURITIES

FIRMS HOUSEHOLDS AND FIRMS

NO MATURITY HIGH

Role of Financial Markets and Institutions Even if markets are efficient, this does not imply that

individual or institutional investors should ignore the various investment instruments available.

Investors normally intend to balance the objective of high return with their particular preference for low default risk and adequate liquidity.

As time passes, new information about economic conditions and corporate performance becomes available.

Announcements that do not contain any new valuable information will not elicit a market response.

Financial institutions are required to resolve the problems caused by market imperfections

They match up buyers and sellers of securities, breakdown securities to the desired size of an investor.

Depository institutions are the major type of financial intermediary which accept deposits from surplus units and provide credit to deficit units

Depository institutions1. Commercial Banks: They serve surplus units by offering a wide variety of

deposit accounts, and they transfer deposited funds to deficit units by providing direct loans or purchasing securities.

2. Saving Institutions: Like commercial Banks, savings and loan associations

offer deposit accounts to surplus units and then channel these deposits to deficit units.

S&L’s have concentrated on residential mortgage loans, while commercial banks have concentrated on commercial loans.

Saving Banks are similar to savings and loan associations, except that they have more diversified uses of funds.

3. Credit Unions: Credit unions differ from commercial banks

and savings institutions in that:They are non-profitThey restrict their business to the credit

union members, who share a common bond.

Functions of Non Depository Financial Institutions1. Finance Companies: Most finance companies obtain funds by issuing

securities, then lend the funds to individuals and small businesses.

2. Mutual Funds:

Mutual Funds sell shares to surplus units and use the funds received to purchase a portfolio of securities.

By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds.

3. Securities Firms:Some securities Firms use their information

resources to act as a broker, executing securities transactions between two parties. The fee is reflected in the difference between their bid and ask quotes.

Furthermore, securities firms often act as dealers, making a market in specific securities by adjusting their inventory of securities.

4. Pension Funds: Many corporations and government agencies

offer pension plans to their employees in which funds are periodically contributed by the employees, their employees or both.

5. Insurance Companies:

Insurance companies receive premiums in exchange for insurance policies payable upon death, illness, or accidents and use the funds to purchase a variety of securities.

Individual surplus units

Depository institutions

Deficit units

Mutual funds

Finance companies

Policyholders

Employers and employees

Insurance companies

Mutual funds

Deposits

Purchase securities

Purchase shares

Premiums

Employee contributions

Exposure of Financial Institutions to RiskBonds and mortgages are subject to interest rate

risk, whereby prices of existing bonds or mortgages decline in response to an increase in interest rates.

Stocks are subject to market risk, whereby the stock market experiences lower prices in response to adverse economic conditions or pessimistic expectations of investors.

All types of securities dominated in foreign currencies are subject to exchange rate risk, in which the currencies dominating the securities depreciate against the investor’s home currency.